Hank Paulson's effort to prop up Fannie Mae and Freddie Mac has various beneficiaries but few gain more than foreign investors.

One effect of the way the quasi-nationalisation is structured is that US institutions may well suffer more than foreign ones. In brief, it is good for overseas central banks and sovereign wealth funds but bad for US regional banks.

The exuberance in non-US markets this morning is a reflection of that fact. The government has had to step in to reassure foreign investors who have become huge buyers of agency debt, but has treated US equity holders harshly.

As Saskia Scholtes and Krishna Guha point out in the FT this morning, US regional banks could well pay the highest price:

"Fannie and Freddie's combined $36 billion of preferred stock is widely held by US regional banks. These banks will be forced to take significant write-downs of their holdings.

"Few banks have provided detailed disclosures on the extent of their holdings in Fannie Mae and Freddie Mac, but among those that could be most affected are Gateway Financial Holdings and Midwest Banc Holdings. According to recent research by analysts at Keefe, Bruyette & Woods, both banks have exposure that amounts to more than 30 per cent of their tangible capital."

Meanwhile, foreign holders of agency debt including that issued by Fannie and Freddie have been given a cushion. The US government has not given full sovereign backing to senior and subordinated debt but it has provided comfort.

This is very significant for all the foreign investors, including foreign governments and wealth funds that have piled into agency debt over the past 15 years, regarding it as a substitute for US Treasuries.

They did not come up with this on their own. Fannie and Freddie travelled the world to persuade foreign investors that their debt was a good bet. It turns out that they were correct, at least about that.

According to recent Treasury figures, foreign holdings of US agency debt rose from $107 billion in 1994 to $1,304 billion in June last year. This outstripped the rate of growth of foreign holdings of both US Treasuries and corporate debt.

Recently, however, foreign investors had begun to get cold feet about agency debt. The FT reported last month, for example, that Bank of China had cut its exposure to agency debt over the summer.

Mr Paulson thus found himself with a fait accompli. The federal government had to give reassurance to foreign investors in agency debt if it wanted to avoid chaos in financial markets and a run on the dollar.

It smacks of debt crises past in Latin American countries, where the ultimate pressure for a bailout came from foreign investors.
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